What you should do as the stock markets crash

published 9 August 2011

Yesterday was yet another shocker of a day for markets.

The Dow Jonesplunged by more than 600 points. And plenty of markets around the world are now in bear territory, from Germany to Brazil to Russia.

As of this morning, the FTSE 100 is getting near to it it's down around 15% or so since the start of August.

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So why is this happening? And what next?

Investors' illusions are being shattered

Investors are waking up to the fact that a number of the assumptions they've been making since March 2009 are just plain wrong.

First, they assumed that the US would rapidly enter a self-sustaining recovery with a little help from the Federal Reserve. That's not happened. And now it looks as though the US economy could even be slipping back into recession before it has ever recovered.

Secondly, they assumed that European politicians would do what it takes' to save the eurozone. After the shock of Greece, how could they fail to put in place measures to protect the rest? But this didn't happen either.

We're rapidly approaching the point where Germany is going to have to give a yes' or no' answer to the only question that matters for the eurozone: "will you pay for the rest of them?" Because the money that the European Central Bank (ECB) is using to buy Italian and Spanish bonds it's got to come from somewhere.

As Stephen Major of HSBC tells the Financial Times: "It looks like the last chance for European policymakers. We saw the Greek interventions, that didn't work. The Irish and Portuguese interventions, they didn't work This isn't going to be something that resolves Europe's problems right now".

And third, investors thought that if all else failed, good old China would come to the rescue. This isn't panning out the way they'd hoped either. China's inflation continues to be a problem. This morning we heard that consumer price index inflation hit 6.5% in June. That was higher than expected (analysts had thought 6.4%) and suggests that the country can't afford to go easy on the interest rate hikes.

In other words, the recovery' was fake, and now we're running out of stimulus options to pump up asset prices again. Interest rates are at rock bottom levels. And while governments may not be genuinely cutting in the developed world public spending, it certainly isn't growing at the rate it did during the boom times. The consumer is still too skint to pick up the slack, and companies aren't keen to invest in such uncertain times.

We're running out of options for delaying this crisis

What's the end result? Anything geared to global growth is tanking. The Aussie dollar my favoured barometer for sentiment on China and commodities fell below parity with the US dollar yesterday. Less than a month ago, it was up at $1.10.

And stocks everywhere are diving. Bear markets (falls of more than 20%) are now firmly in place in countries from Germany to Russia to Brazil though not in the UK yet.

Is there any good news out of this? In 2008 and 2009, when markets crashed, central banks had plenty of room to slash interest rates. Meanwhile, commodity prices dived, bringing the cost of petrol down sharply.

As a result certainly in Britain, where plenty of people had home loans tied to the Bank of England rate many people saw their cost of living fall. Indeed, if you held onto your job and owned a home, Lord Young's ill-advised "you've never had it so good" riff was probably true enough.

It's not the same this time. Yes, oil prices are falling. But mortgage rates are as low as they can go. There's no chance of a sugar rush' from that direction.

What about quantitative easing (QE)? I think given the results so far it's fair to describe QE as the process of giving the banks Monopoly money to punt on the markets. The Bank of England prints money to buy gilts from the banks. The banks then take said money and stick it into stocks and commodities, rather than lending it to businesses or people. It's a similar process when the Fed does it in the States.

So it's hard to see how more of the same can help. The yields on UK and US government bonds are already incredibly low. Panicked investors have seen them as safe havens' for the time being. And if more QE simply drives up commodity prices further, that'll make things even worse consumers are already at breaking point.

We'll see if the Fed has anything else up its sleeve when it meets tonight. Direct intervention in the US housing market has been vaguely whispered about in some circles. But I don't think things are quite at the point where Ben Bernanke will come out with anything concrete.

What can investors do?

Our view for quite some time has been to stay defensive gold, blue-chip stocks and cash and if that's the rough shape of your portfolio, then stick with it. There will probably be buying opportunities further down the road, but for now, I don't see any need to pile into the market. Build a watch-list of stocks that you've had your eye on in the meantime.

What sort of stocks? Well, Lex in the FT makes an interesting point on safe havens this morning. "Only five S&P 500 stocks rose from world stocks' peak in October 2007 to the trough on March 2009: one of them was Walmart." Why? Because "Walmart can consistently produce cash."

These sorts of companies may have underperformed during the rally, but now that investors are looking for safe havens once again, they'll be back in demand. We'll be looking at how to find companies that throw off cash in the next issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, you can get your first three issues free here.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.